10/01/18

Regulation | Tax-Gap Blues

(Global Finance) -- The financial crisis—with the subsequent austerity imposed on citizens—was a turning point in public attitudes. Once upon a time, ordinary citizens might have joked about so-called tax havens. Then governments became strapped for cash, allegations of abuse surfaced through leaks such as the Panama Papers, and people started to feel ripped off. A steady drip of reports about corporate giants’ contortions to reduce taxes (relative to revenues) fueled public anger further.

Tax evasion—denoting illegal strategies—is negligible these days, at least among major multinationals, say tax advisors. As a general rule, multinationals (especially those listed on major stock exchanges) seek to operate within the mainstream of tax planning, explains Sanjay Mehta, tax partner at law firm Katten Muchin Rosenman in London.

Nevertheless, tax avoidance—following the letter of the law, though typically not its spirit—still leaves corporates plenty of options. “Multinationals can employ a variety of strategies, usually based on optimizing reliefs, deductions, exemptions and tax rates made available by national tax laws, as well as securing relief under applicable international agreements (such as double-tax treaties and EU directives),” says Mehta. “These strategies can involve arrangements ranging from the simple to the complex.” It is in part this complexity that makes the difference between evasion and avoidance increasingly irrelevant in terms of public perception, thus driving political efforts to rein in such schemes.

According to the OECD, legal tax-avoidance strategies cost governments around $240 billion a year. IMF researchers Crivelli et al. put the bill even higher, costing OECD countries around $400 billion and developing countries $200 billion a year. The latter group, which most needs the revenue, is thought to lose 6% to 13% of total tax revenues; even OECD countries lose 2% to 3%.

What’s more, the most recent published evidence suggests that avoidance is increasing. “In the 1990s, only 5% to 10% of US multinationals’ profits were declared outside the country where the economic activity took place,” notes Alex Cobham, economist, chief executive of the Tax Justice Network and a visiting fellow at King’s College, London. “By 2012-2013, this figure was between 25% and 30% of global profits. Now we’re being asked to take on faith that this rapid growth has been reversed.”

How Did We Get Here?

Today’s tax-avoidance behaviors are wired into the system. “The international tax system was created in the late 1920s following tax hikes imposed to pay for World War I, which [had] led to appreciable double taxation,” explains Richard Collier, associate fellow at the Saïd Business School, Oxford University. While postwar agreements addressed the double taxation, he continues, negotiators at the time “assumed that parent companies would be based in the home country and branches or subsidiaries would be established in ‘source’ countries.” Globalization has since created new supply chains and markets, while regulation has changed the roles and functions of different types of entities.

The 1920s rules also paved the way for tax competition, which frames today’s debate. “Under the current international tax system, a country is effectively incentivized to operate a tax-competition agenda,” says Collier. Most countries play this game—look at current Republican corporate-tax-cut proposals. Collier points out that Bermuda or the Cayman Islands are pursuing a more extreme version of the developed countries’ tax-competition policies. Few governments explain this to their irate citizens, instead resorting to platitudes about “rooting out avoidance” and “everyone paying their fair share.”

What’s taking place in some cases, though, is clearly not legal avoidance but very illegal evasion. In March 2016, two subsidiaries of Cayman National Corp. pled guilty to conspiring with US-taxpayer clients to hide millions from the IRS, evading taxes on the income. The company agreed to pay a $6 million fine and hand over the cheating customers’ data.

What's Being Done To Fix It?

In 2009, the G20 member states committed to cracking down on bank secrecy and targeting tax havens, reflecting citizens’ concerns about opacity, accountability and, to some extent, legal profit-shifting by multinational corporations, recalls Pascal Saint-Amans, director of the OECD Centre for Tax Policy and Administration. “At at the height of the crisis,” according to Saint-Amans, “the G20 declared that bank secrecy was over and committed to take action against non-co-operative jurisdictions, including tax havens.”

The resulting base erosion and profit shifting (BEPS) project targets tax strategies that artificially shift profits to low- or no-tax locations. On November 23, Trinidad and Tobago became the 108th country to sign up for the 15 actions intended to give authorities the domestic and international tools they need to make BEPS work.

Clare Munro, senior tax partner at accountancy firm Lubbock Fine in London, says new country-reporting measures and increased awareness of transfer-pricing abuse, among other measures, should make aggressive tax structures less feasible. Transfer pricing requires pricing on an arm’s-length basis, for example. “Interactions between a company and, say, its Cayman Islands subsidiary should be treated for tax purposes as if the same transaction were undertaken with a third party,” explains Munro. “There should be no artificial shifting of profits.”

In the past, emphasis on contractual allocation of functions enabled high-value profitable activities to be booked in a country with a low tax rate, while an exemption was obtained for related activities in a higher-tax jurisdiction. BEPS changes that. “Actions 8 to 10 of the BEPS project on transfer-pricing guidelines explicitly link people to profits,” explains Bill Dodwell, head of tax policy at Deloitte in London. “Unless there are clear corporate activities taking place in a country, profits cannot be attributed to it.”

Is BEPS Working?

Almost every tax specialist consulted for this article described the corporate practices revealed by the Paradise Papers leak as historical and said new rules mean corporate tax-dodging is fast declining. That doesn’t wash with Cobham of the Tax Justice Network. “These leaks go up [only] to 2016,” he says. “Are we saying that all inappropriate behavior stopped then?” He points out that a higher share of profits are being booked outside the country of activity than in the ’90s.

Cobham also dismisses another claim by defenders of the status quo: that the Paradise Papers reveal exceptions, not the rule. He cites Apple, known to seek a near-zero tax solution that ignores where its real activity takes place. “Apple is one of the world’s best-known and largest companies, not some outlier from the mainstream of multinationals,” Cobham says. “The expectation is that a lot of firms will follow suit. In fact, there’s nothing to suggest they haven’t already.”

Cobham says the OECD’s defense of the arm’s-length principle through BEPS will ultimately fail. “[It is] hamstrung by contradictions,” he notes, such as between Action 11 and Action 13. Action 11 requires reporting of country-by-country data to execute, but “objections from some countries ensure that data is not publicly available; it is only [required to be] available to tax authorities in the company’s headquarters country.”

What More Can Be Done?

Cobham believes the world is already looking beyond BEPS and asserting instead that taxation should be based on the share of activity that occurs in a country, aligned with profits.

“Naysayers claim that such an approach would have to be global to work. But it could be done unilaterally,” he says. Post-BEPS, the US has looked at shifting to a unitary-tax approach using a destination-based tax primarily focused on sales, he notes. Meanwhile, he adds, “the G77 [group of developing countries] are seeking a UN body with power to set more-appropriate rules.”

The EU is perhaps furthest along in making a common consolidated corporate tax base a reality using sales, employment and tangible assets to allocate taxable profits. In September, the European Commission called on the European Parliament to reform the tax system for the modern world, “where businesses rely heavily on hard-to-value intangible assets, data and automation.”

The first step of the Commission’s proposal is the allowance of loss consolidation across the EU, to permit 100% immediate offsetting. The second step is to apportion tax across the EU according to activity, to address intra-EU profit shifting. The third step would address the potential for such a measure to exacerbate incentives to shift profit outside the EU. “Within the next two years, we will see at least one of these stages being legislated,” says Cobham. “To tackle profit-shifting, it would make most sense to move immediately to the third.”

Many observers believe a unitary approach is unlikely and unnecessary. “To suggest that OECD BEPS does not address the underlying issues is unfair,” says Saint-Amans. “It is true that transfer-pricing rules reflect a conception of multinationals as a myriad of economic entities and therefore require them to make sales to each other at market prices. Clearly, this legal principle is disconnected from the economic reality of where profits are created.”

However, this approach reflects the reality that individual governments remain sovereign, according to Saint-Amans. “They do not believe that global apportionment will work, and therefore it is impossible to proceed on that basis,” he says.

Rather than seeking utopian solutions, we should celebrate recent progress. “A decade ago, there were only vague agreed-upon rules on transfer pricing,” says Saint-Amans. “Today we have four minimum BEPS standards and have ended bank secrecy.”

Deloitte’s Dodwell says suggested alternatives are undesirable, even if possible. “Turnover taxes are a poor way of taxing, as they don’t equate to profits,” he notes. “Although there are some extremely profitable tech companies, there are also a lot of smaller tech companies that make small profits or have large losses. New and innovative start-ups might be hampered if they were taxed based on revenues.”

A New Era?

It’s easy to be cynical about corporate taxpayers, yet it seems the debate about corporate tax has fundamentally shifted. While BEPS may not allow journalists and the public to scrutinize company-level data, more people than ever are tracking companies’ behavior—listed companies (at least) have paid attention.

“In the social-media age, the perception of abuse can quickly damage a multinational’s reputation even if nothing illegal actually takes place,” says Munro at Lubbock Fine. “With regular media scrutiny, multinationals are likely to find it more difficult to justify continued use of tax havens.”

Mehta at Katten Muchin Rosenman adds that public companies’ audit committees increasingly focus on reputational risk and whether specific tax strategies are defendable. “Most multinationals prefer an effective tax rate that derives from sensible planning, and is therefore stable and predictable, over one that fluctuates as potential tax savings from aggressive structures are clawed back by tax authorities.”

It’s also important to note that tax havens still have legitimate functions for multinationals, according to the OECD’s Saint-Amans. “For example, special-purpose vehicles are necessary if [firms] have a joint venture with another company and require tax neutrality.” But the days of schemes designed only to minimize tax bills look numbered. The outcome, according to Dodwell at Deloitte, is likely to be higher tax bills: BEPS Action 11 estimates corporate tax losses of 4% to 10%.

The advances achieved so far risk being lost as new technologies change the landscape. While the international tax system may finally be catching up with globalization, many corporates will soon be able to create value wherever it suits them. Taxing the digital economy fairly—for companies and citizens both—will remain a formidable challenge.